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Five Investment Theories to Take Note Of

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An investment theory can be referred to as the body of knowledge used to back up the decision-making process of selecting proper investments for the correct purpose (or application). More often than not, investing in the stock market is seen as a process in which an investor only needs to buy low and sell high to make gains. However, there is more to financial market trading than merely buying shares cheaply and selling them when they have risen substantially.

Theories, on the other hand, can also be purely academic and of little practical value to the modern investor. On a positive note, Jacob Furnstedt, Wilkins Finance market analyst, believes that understanding investment theory is a good way to work out your online financial market trading strategy. However, he is also quick to point out that relying solely on these theories is not wise. It’s important to look at overall market trends as well as financial analysis and technical indicators.

Five Relevant Investment Theories

Before we take a look at 5 of the most important investment theories, it is also vital to note that some of these investment theories have been termed as controversial because rather than investigating the financial aspect the business you are interested in investing in, these theories rely solely on technical methods to forecast market trends.

The 50% Principle

According to Investopedia, “the fifty percent principle predicts that, before continuing, an observed trend will undergo a price correction of one-half to two-thirds of the change in price.” In other words, if an asset’s price is on an upward trend and has gained 10% in value, it will drop 5% before rising again. Furthermore, if the asset’s price is on a downward trend and its price has fallen by 10%, it will increase by 5% before continuing on its downward trend.

Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) posits that it is impossible to “beat the market” because capital market performance causes stocks to always trade at their appropriate value on the financial markets. Thus, it is impossible for traders to invest in undervalued shares or to sell their shares at overvalued prices. Consequently, according to the EMH, it is impossible to outperform the markets by buying low and selling high. This theory states that they only way an investor can make money by trading on the global financial markets is by increasing his exposure to risk.

Rational Expectations Theory

The Rational Expectations Theory is an economic theory. And it states that investors make trading choices based on their rational outlook; ergo, what has happened in the past, the current socio-economic and geopolitical events, and the information that is available to predict future trends. In other words, the Rational Expectations Theorysuggests that the current expectations in the economy are equivalent to what people think the future state of the economy will become.” Furthermore, this theory is in direct juxtaposition to the view that government policy influences financial market movements and people’s decisions.

Greater Fool Theory

The Greater Fool Theory postulates that the price of an asset (stock) is not determined by its fundamental value, but by financial market investors’ irrational ideas and expectations.

In other words, the theory implies that an investor can continue making money from investing as long as there is a ‘greater fool’ to buy his assets. Therefore, the price of an asset can be justified by an investor as long as he believes that there is that there is another buyer who is willing to buy the stocks at an even higher price.

Finally, it goes without saying that this is a very dangerous theory to follow. The reality is that at some stage all of the “fools” will run away and the investor will be stuck holding overpriced stock.

Odd Lot Theory

The Old Lot Theory is a technical analysis theory based on the premise that the single investor (or trader) is always wrong. This strategy assumes that small investors have a threshold that is low-risk. Thus, they tend not to hold a stock for the long-term and end up selling it shortly after purchasing it. Consequently, according to this premise, it is a good idea to buy financial market assets if the small investors are selling their assets.

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